FINANCIAL MARKETS BIGGEST THREAT IS ONLY A FEW DAYS AWAY

Jun 21, 2016

Hussein Sayed, Chief Market Strategist at FXTM

Britain leaving the European Union has been so far the biggest global risk event for financial markets, and with less than one week to the EU referendum date investors are becoming more concerned with choppier trading activities expected to carry on until the markets get an answer on Friday, 24th June.

One month earlier, voting polls indicated that a Brexit was unlikely to happen, but recently these polls are not helping investors to position themselves, as they are providing contradicting results which is making it too difficult to predict the outcome. All we can say at the moment is that it looks like a very close call.

Trade is the most significant risk

From an economic perspective, trade is the most significant risk if the leave vote wins. The campaign in favour of voting for Brexit argues that UK can negotiate new trade agreements with EU members, but neither U.S. President Barack Obama, nor Germany’s Finance Minister Woflgang Schauble agree, and most recent comments from Mr. Schauble clearly seem to block the way for the UK to enjoy the benefits of the single market without being an EU member, such as Switzerland. This suggests that separate trade deals might take couple of years if not a decade to be crafted, putting downside risk on economic growth in the short and medium run.

While Brexit supporters claim that the Bremain camp is over-exaggerating the long term economic consequences of UK leaving the EU, the most likely immediate impact will be:

Businesses putting investments on hold, and reducing their workforce or placing a freeze at best.

Larger account deficit due to stop or reduction in foreign direct investments inflows.

Tightening financial conditions leading to higher interest rates.

Sharp fall in sterling leading to higher inflation, less real income and drop in consumer spending.

Slight drop in house prices on the prospect of lower future migration.

Prospects of downgrades from rating agencies sending Gilts lower.

Equities plunging, but varying upon each sector.

Banking sector, the most vulnerable to Brexit

Although the consequences and exact impact of a Brexit cannot be reliably measured and would depend on the terms of the divorce, markets most probably are heading into a prolonged period of uncertainty, and investors will sell risk assets first, then ask questions.

Among the FTSE 100 companies, the banking and financial services sectors are those to worry most about. London’s position as the world’s top financial center will be at risk as selling products across the EU will require new set of regulations. Retail, construction, and travel will be impacted but at a lesser degree. However, the basic resources sector is the least correlated to a Brexit. One should be more concerned on the FTSE 250 which derives half of its revenue from the U.K. as opposed to FTSE 100 which has less than a third of its revenue driven domestically.

As for the pound, different models give you different figures, whether the sterling will fall 10, 20 or 30% on a Brexit clearly it’s going to be the biggest loser, and most certainly GBPUSD will drop to levels last seen in more than two decades. The last time GBPUSD traded below 1.35 was in 1985.

EU indices to fall double digit

A leave win might not stop there, but a domino effect across some of the remaining 27 members will likely spill over, especially with Euroscepticism rising across the bloc. Whether the motives are austerity or immigration, the state of the EU as whole might be put into question. Equities across the EU will also be hit hard, considering that the equity markets have stayed reasonably calm and did not price in a Brexit scenario. I guess it would be an easy call to say that most equity indices will fall by a double digit in the aftermath of UK leaving the EU.

Bonds and gold to attract investments

German 10-year bund yields will likely be the third to join the Japanese and Swiss bonds into negative territory, and this could happen even before the referendum date on 23 June, as we are already close to zero. U.S. bonds will also be attracting lots of investors seeking safety and the yield on its 10-years notes could revisit 2012 record low at 1.4%. Meanwhile the yellow metal will be given a chance to shine again after being the best major asset class in Q1 2016.

Conclusion

In summary, a Brexit impact on the economy remains unknown in the longer run, and it’s very difficult to justify whether Britain, without EU, would be better or worse in 10 years until we know the details of post-exit relationship with the EU countries. However, in the shorter term there would inevitably be a high degree of uncertainty until most of these questions are answered. What trade agreements to be crafted? What will a new immigration system look like? What will the impact be on the City of London as a world financial hub? Will the Scottish call for another referendum on independence? And most importantly, will EU-sceptics rise and therefore damage Europe geopolitically?